Special Considerations for Investment Clubs

Special Considerations for Investment Clubs

Investment clubs have a long history in the United States as a way for people to gather socially, pool their money, evaluate potential investments together, and make collective investment decisions. The vast majority of investment clubs focus on the stock market. To our knowledge, no one had created an investment club dedicated to making investments in local small businesses until a chapter of Slow Money in Maine formed the No Small Potatoes Investment Club. They shared their documents freely, encouraged other communities to replicate their model, and made themselves available to support others following in their footsteps; thanks to their commitment to educate others, we are able to present the issues around local investing clubs here in this guide.

The most striking difference between investment clubs and networks is that investment clubs pool their members’ money and make collective investment decisions, and networks do not pool their money, and their members make their own independent investment decisions. The fact that clubs pool money gives rise to a number of benefits and challenges for clubs:

1) Easier access to a diversified portfolio. As long as the club’s investments are diversified (and they should be), a stake in the club will be a lower risk, diversified local investment. Club members should agree on diversification rules (such as the maximum percentage that can be placed in any one investment, and in any one industry) before launching, and write them into the club’s membership agreement.
2) Member meetings are well attended and tend to be more engaging because club investment decisions need to be made, and everyone has actual money at stake. Members get to know each other better because they are working together more regularly.
3) The club must have a bookkeeper or accountant to track the coming and going of funds, a tax preparer to file the club’s tax returns, and a lawyer to review its legal documents. While some clubs may be lucky enough to have these services provided by members, others must share costs among the members, which ultimately has the effect of reducing net investment returns.
4) Tax returns for the members may be slightly more complex, and yet there are no major tax benefits to investing through a club.
5) Investment research (due diligence) usually follows a defined process and is shared openly with, and reviewed by, the whole group, ideally resulting in higher quality investment decisions.
6) Clubs can encounter challenges around the issue of how much money each member has contributed to the club. Technically speaking, members each own a share of the club itself, and people with more money at risk in the club may want more control. To help with this issue, the club should designate minimum and maximum amounts that can be contributed by each member, as well as how votes are counted: by the member’s percentage ownership of the club’s capital, or “one person, one vote.”
If all members are required to contribute similar amounts of money, then the minimum amount chosen will have to be low enough to be affordable for all of the club members. As a result, the club itself may have a fairly limited total amount of capital to invest, and a correspondingly limited economic impact. It may not be able to support larger investments, because the club itself will need to diversify its investments, placing no more than, for example, 15% of its total capital in any one deal.

One common solution is to create hybrid club/network groups which allow for, and even encourage, members with more money to invest to make side deals with investees outside the club, which has the effect of raising the group’s collective potential impact.
The bottom line for investment clubs is that there are many benefits, but there is also more overhead and potentially less economic impact. The legal, accounting, and tax costs are generally the same for a club with lots of money or little money. The due diligence process consumes the same amount of the members’ time and energy whether investments are large or small. Before committing to a club model, ensure that your club’s economic impact (as measured by how much your properly diversified club can invest in any single deal, as well as its total capital) will be worth the time and money that the members will have to spend on it.

From a legal perspective, any time investors pool their money, they have essentially created a fund, and therefore, the laws that cover mutual funds kick in. Investment clubs have a special exemption from this law, however, as long as they adhere to the requirement that every member of the club must vote and participate actively in investment making decisions. No passive members are allowed. Also, state securities laws and regulations vary, and may affect investment clubs in different ways from state to state, so it is advisable to check with your attorney, state securities regulators, and/or other investment clubs in your state about state-specific legal issues relating to investment clubs.